“To invest successfully, one doesn’t need a stratospheric IQ. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework” – Warren Buffet


Over the last couple weeks, we have penned two investor education articles on the value of investing frameworks. The first explained why investing frameworks are invaluable tools for any investor.  The second looked at why some frameworks are better than others and outlined three key characteristics of a solid, value-based framework. This article lays out the elements of our framework for investors who want to use it in their daily decision-making process.

We use this framework ourselves in our own investing, and have seen the degree to which it helps everyone from the professional analyst sitting in front of a stack of financial statements and conference call transcripts, to the individual investor listening to a friend’s hot stock tip on the golf course, to the family office manager getting pitched a new investment idea by his or her private wealth manager, to the registered investment advisor figuring out what investments to make for his or her clients.

The Framework’s Elements

As we mentioned in our last article about the three characteristics of a sound investing framework, our framework rests on the foundation that an investment’s value is the total cash a company generates on behalf of its owners over its economic life.

A framework that focuses in on the process of cash flow generation makes it easy to assess investment ideas because there are only a very few elements which can possibly influence cash flows.

To generate value, a company must:

  • Generate revenues
  • Convert revenues into profits
  • Invest some portion of profits to boost future profit growth

As value investors with a long time horizon, we do not concern ourselves with every quarterly blip in revenues or profits, but instead use our understanding of the company to forecast a range of likely values over the next few years. We also look at “profit” from the standpoint of a true owner using a common sense, cash-based profitability metric called Owners’ Cash Profits (OCP).

Any investment idea can be analyzed in terms of this framework, from a software company to a manufacturer to a REIT. We think of the framework in terms of a “waterfall,” an example of which, published to our members in May of last year, shows our best- and worst-case forecasts for Apple’s (AAPL) valuation drivers and our resultant valuation range:

While this waterfall diagram is the product of careful analysis, the analysis was 100% governed by the basic framework described above. We make a point to keep focused on factors that can materially affect the three fundamental drivers, and resist the temptation to be drawn into a maze of details that do not have a material impact on cash flows long term.

The cash generated by the firm over its economic life is expressed through our measure Free Cash Flow to Owners (FCFO), and ties directly to the valuation range shown at the bottom of the diagram.

So, when any new idea arrives on your desk, do this: stop, relax, and focus on the following important questions.

  1. How is this investment idea generating revenue? Are there barriers to its ability to meet demand or limits to the level of demand for its products or services? What are the risks to its ability to generate revenues? How fast can those revenues grow in the future?
  2. How efficiently and consistently does this company convert revenues to profits (i.e., how profitable is it)? In the worst and best cases, what changes about its expense profile and how does its profit margins compare to its competition? Is there something unique to the business and its offering that allows it higher profits?
  3. What investments will this company need to do to keep growing? Is the company spending enough to enable it to keep growing at a good clip far into the future? How much of the company’s stock buyback program ends up soaking up dilution from issuing stock to its employees?

The cash generated after the company receives revenues, pays costs to maintain the business as a going concern, and invests to boost future growth is our measure Free Cash Flow to Owners. The best- and worst-case estimates of those cash flows, “discounted” to their present value, constitute the company’s fair value range. The only step for us to make after estimating the fair value range is to compare that to the price at which the company’s shares are trading.

We provide simple tools to allow investors to keep track of these numbers and derive a valuation range, but the tools are less important than the framework. If your framework is good, your tools don’t have to be fancy.

A Solid Framework in Action

A few years ago, I had the chance to hear an influential institutional investor talk about an investment that he had made. This investor, a man who was responsible for managing tens of billions of dollars, framed the investment in terms of this straightforward argument:

“This company is generating $100 in revenues right now. Out of that, it makes around $20 in profits and spends around $7 on its investments. The investments it is making right now are smart, and because of structural factor X and Y, we think profits will grow to around $100 in a few years’ time. That is worth at least $1,000 to us and right now, the company is trading for a market cap of $600. Looks like a good investment to us.”

That’s it. An example of our framework in a nutshell in five simple-to-understand sentences.

You might say that this is too simple. It is simple, but sometimes it is not easy. Fear prompted by macroeconomic news, a sharp fall in the price of the shares, an analyst’s negative comments or a dozen other things can cause even the most experienced investor to doubt their judgement. We believe that Rob Arnott’s comments at the Spring 2017 Grant’s Conference are right on target: “Bargains do not exist without fear.”

We call the psychological and social issues that cause these kinds of fears “behavioral and structural factors” and have a course to talk about how to deal with them effectively. Being able to control one’s emotions is a vital element of a successful investing framework!

In our final article in this series next week, we will apply our framework above to three real-world investing decision scenarios:

  • A business associate gives you a tip about a “can’t miss” stock.
  • Your advisor recommends a position change
  • Jim Cramer screams “SELL!!!!, SELL!!!!, SELL!!!!!”